Some patterns are just imagination. They look impressive, and may even have
exotic names, but they are not particularly reliable or useful for making
trading decisions. We avoid these patterns. The head and shoulders pattern
is a very reliable way to understand the developing behaviour of the market.
The head and shoulders pattern consists of three distinct peaks. This
pattern cannot be reliably identified until the right shoulder, or third
peak, has formed or been confirmed. Unfortunately, by this time the market
has already declined. However the pattern is very useful for setting targets
for the coming market fall. Knowing these points helps traders to plan when
to re-enter the market.The
left ‘shoulder’ is formed at the end of a long uptrend that usually has been
in place for several months or longer. Prices fall far enough to signal an
end to the previous uptrend. This leaves a peak, or shoulder. Prices then
rally to form another peak that is higher then the left shoulder. Prices
decline from this peak and create a new short term downtrend. This forms the
‘head’ of the pattern. Usually it takes several weeks between the peak of
the left shoulder and the peak that forms the head.
The pattern cannot be fully recognised or confirmed until the right
‘shoulder’ is formed. Again this usually takes several weeks as prices must
fall, rally to a new lower peak, and then fall again. Only after the right
shoulder has been confirmed can traders really recognise a head and
shoulders pattern. This is a pattern that develops over months, not days.
This pattern confirms a high probability that the previous long uptrend has
ended, and, more importantly, it sets targets below the current price for
the following downtrend. These targets are set by plotting a ‘neckline’ and
then measuring the distance between the neckline and the top of the head.
The neckline joins the base of the left shoulder with the base of the
right shoulder. It may slope up, down, or horizontally. The slope does not
have any particular significance. The neckline provides a measurement point.
The distance between the top of the head and the neckline is then projected
downwards from the neckline to set a lower target. This is the level where
we expect the market to pause and rebound. Often these targets look very
low, but they are reached in many cases. It is this feature that makes the
head and shoulders pattern so reliable.
The KLCI chart shows the recent head and shoulders pattern and the index
targets at 860. Some traders used this pattern to establish buying orders at
860. They were able to enjoy a rapid rebound from this target area as the
index moved upwards. Other traders prefer to wait for proof that these
targets are valid. They were also able to join the new uptrend early in its
development. This is the most useful application of the head and shoulders
pattern. It confirms the end of an uptrend, and helps traders to decide the
best time to re-enter the market as the new downtrend hits the lower targets
set by measuring the head and shoulders pattern.